Saul Centers. nineteen hundred ninety eight Annual Report. to shareholders

Saul Centers 1998 nineteen hundred ninety eight Annual Report to shareholders

Historic OPERATING PERFORMANCE Total Revenues (in millions) $75 $70 $65 1997 1998 $60 1995 1996 $55 1994 Portfolio Composition BASED ON PROPERTY OPERATING INCOME Property Type $50 Property Operating Income (in millions) $55 76% Shopping Centers $50 $45 1997 1998 24% Office $40 1995 1996 1994 $35 $30 Geographic Location Funds From Operations (in millions) $35 81% Metropolitan Washington, D.C./ Baltimore area $30 19% Rest of U.S. 1998 $25 1997 1994 1995 1996 $20 2SAUL CENTERS $15

Shares of Saul Centers are traded on the New York Stock Exchange under the symbol BFS. Saul Centers, Inc. is a self-managed, self-administered equity real estate investment trust headquartered in Chevy Chase, Maryland. Saul Centers currently operates and manages a real estate portfolio of 34 community and neighborhood shopping center and office properties totaling approximately 5.9 million square feet of leasable area. Approximately 80% of the cash flow is generated from properties in the suburban Washington, D.C./Baltimore area. Saul Centers primary operating strategy is to focus on continuing its program of internal growth, renovations, and expansions of community and neighborhood shopping centers, which primarily service the day-to-day necessities and services subsector of the overall retail market. The Company plans to supplement its growth through selective development of new office and retail properties and acquisitions of operating properties as appropriate opportunities arise. 3

Financial HIGHLIGHTS Another Active and Exciting Year Revenue growth was driven by a strong 7.3% increase in 1998 base rents from stabilizing redevelopments, improved rental rates on expiring leases and leasing percentage increases. Summary Financial Data: Year ended December 31, 1998 1997 1996 1995 1994 Total Revenues SAUL $ 70,583,000 $ 67,717,000 $ 64,023,000 $ 61,469,000 $ 57,397,000 C Funds From Operations (a) $ 29,768,000 $ 27,637,000 $ 25,122,000 $ 24,636,000 $ 24,192,000 Average Shares Outstanding (assuming operating partnership units fully converted) 17,233,047 16,690,417 16,423,984 16,284,666 16,272,263 Funds From Operations Per Share $ 1.73 $ 1.66 $ 1.53 $ 1.51 $ 1.49 Property Data: Number of Properties 34 33 33 32 32 Total Portfolio Square Feet 5,901,000 5,821,000 5,806,000 5,657,000 5,632,000 Shopping Center Square Feet 4,990,000 4,953,000 4,938,000 4,789,000 4,765,000 Office Square Feet 714,000 671,000 671,000 671,000 670,000 Industrial Square Feet 197,000 197,000 197,000 197,000 197,000 Average Percentage Leased 90% 90% 89% 90% 90% More detailed financial information is available from the Company s Annual Report Form 10-K. (a) Funds From Operations, presented on a fully converted basis and the most widely accepted measure of operating performance for real estate investment trusts, is defined as net income before extraordinary and non-recurring items, and before real estate depreciation and amortization. All years are presented in conformance with the National Association of Real Estate Investment Trusts guidelines adopted effective January 1, 1996. 4

Message TO OUR SHAREHOLDERS Financial Highlights 1998 marked a year of increased earnings, improved leasing levels, and continued significant accomplishments in the areas of redevelopment, renovation and tenant upgrades. Funds From Operations (FFO) increased 7.7% to $29,768,000 for the year ended December 31, 1998 compared to $27,637,000 for the 1997 year. FFO is presented on a fully converted basis and is the most widely accepted measure of operating performance for real estate investment trusts (REITs). FFO is defined as net income before extraordinary and non-recurring items and before real estate depreciation and amortization. For the quarter ended December 31, 1998, FFO increased 6.6% to $7,864,000 ENTERS compared to $7,374,000 for the 1997 quarter. On a per share basis, FFO was $1.73 per share for the 1998 year, a 4.3% increase over the prior year. For the quarter ended December 31, 1998, FFO increased 2.0% to $0.45 per share over the comparable 1997 quarter. During 1998, the Company paid four quarterly distributions of $0.39 per share to shareholders, of which 74.2% was taxable as ordinary income and 25.8% represented a non-taxable return of capital. The annual dividend of $1.56 compared to 1998 FFO of $1.73 represents an FFO payout ratio of 90.2%. The Company s annual payout ratio has been reduced in each of the past five years, allowing the Company to retain additional capital for reinvestment into its assets, while at the same time, increasing dividend coverage. Total returns, price appreciation combined with dividend yield, in all sub-sectors of the REIT industry were negative in 1998; however relatively strong retail sales and overall stability in the performance of retailers stocks helped retail REITs outperform other sectors. With a year-end dividend yield of 10.0% compared to an approximately 7.5% average yield for all equity REITs and a near 5.5% yield for the 30 year bond, we continue to view Saul Centers as an attractive long term vehicle for both yield and total return to investors. 5

Message TO OUR SHAREHOLDERS Property Operations Total revenues for 1998 increased 4.2% to $70.6 million compared to $67.7 million for 1997. For the quarter ended December 31, 1998, revenues increased 1.7% to $18.1 million compared to $17.8 million for the 1997 quarter. Revenue growth was driven by a strong 7.3% increase in 1998 base rents from stabilizing redevelopments, improved rental rates on expiring leases and leasing percentage increases. Property gross margins improved in 1998 from 73.3% to 74.8%, a product of aggressive asset management which resulted in both revenue increases and a 2% decrease in operating expenses. In 1998, same center operating income increased 4.2% for the shopping center portfolio, 8.3% for the office properties and 5.1% overall. The Company s same center shopping center growth throughout the past 15-years has averaged a compounded annual rate of 7.0%. Space leased to tenants averaged 89.9% for 1998 compared to the 1997 average of 89.5%; however significant fourth quarter leasing activity increased the year-end 1998 percentage leased to 92.1%. This current leasing percentage is a five year high for the Company. SAUL C The widespread credit tightening in REIT industry capital markets during the latter part of 1998 had little impact on Saul Centers, as the Company has historically relied upon an internal growth operating strategy which requires a limited amount of external capital. During the past five years, the Company has adapted to changing shopping patterns and shopper demographics by de-malling outdated mini-malls and by expanding and renovating its shopping centers to accommodate today s most successful retailers. During 1998 and 1999, Saul Centers continued and has plans to continue with this defined operating strategy of internal growth through redevelopment, expansion and renovation. 6

Eighteen of our 30 shopping centers are anchored by a supermarket and other retailers which offer mainly everyday convenience, non-branded and non-discretionary goods and services. Real estate is primarily a location business. The Mid- Atlantic region, the Company s primary market area, remains strong economically with few signs of overbuilding. According to an industry demographic report conducted in 1998, the Company ranks among the top five shopping center REITs in terms of the population count and the household incomes of those residents living within 3 miles of the centers. As always, the marketing of retail space in today s environment requires continuous attention to the synergy of tenant mixes and consideration of the shopping needs of a center s trade area. ENTERS New shopping trends such as the explosion of Internet commerce and online shopping in 1998 are making headlines as a new form of retailing. In general, however, it is currently believed that electronic retail will have very little impact on neighborhood and community centers in economically and demographically stable trade areas because of the products and services they offer namely, convenience and necessary goods and services such as groceries, restaurants, dry cleaning, hair and nail salons, etc. Eighteen of our 30 shopping centers are anchored by a supermarket and other retailers which offer mainly everyday convenience, non-branded and non-discretionary goods and services. Redevelopment Activities Shopping Centers The major component of Saul Centers growth has been the redevelopment of older shopping centers to fit current requirements and to keep pace with changing retail patterns. The Company s major 1998 redevelopment and renovation activities focused on Beacon Center, French Market, Shops at Fairfax and Thruway shopping centers. Beacon Center, located in Alexandria, Virginia, began 1998 as a 290,000 square foot groceryanchored shopping center with an enclosed mall section. The Company redeveloped the center by replacing the enclosed mall with a new Lowe s home improvement superstore and 8,000 square feet of new small shop space. The completed center will total over 350,000 square feet, with Lowe s and Giant Food providing a stable tenant base while occupying over 55% of the center. The enclosed mall has been demolished and a building pad has been prepared for the commencement of construction of the 148,000 square foot Lowe s store and garden center. Construction of the new shop space has been completed and is fully leased to service tenants including Starbucks, a hair salon and a dry cleaners. Lowe s is expected to open in the summer of 1999. Redevelopment of the Beacon Center in Alexandria, Virginia to include a new Lowe s home improvement superstore, scheduled to open in the summer of 1999. 7

Message TO OUR SHAREHOLDERS French Market, located in Oklahoma City, Oklahoma, is a 213,000 square foot grocery-anchored shopping center. In February 1998, we commenced construction on a facade renovation and retenanting of a 103,000 square foot anchor space. Construction of the first three new spaces, Bed, Bath and Beyond, Lakeshore Learning and BridesMart, was completed during the year, and for business. A lease is expected to be completed shortly with a national retailer for 25,000 square feet. The final 20,000 square feet of space is currently under negotiation. Thruway is a 345,000 square foot center located in Winston-Salem, North Carolina and anchored by Harris Teeter and Fresh Market grocery stores, Eckerd Drugs and SteinMart. The Company renovated the facade of this shopping center in 1997. During 1998, the Company successfully retenanted two anchor spaces which became available after one retailer s bankruptcy and the closing of a former Woolworth s store. New leases were signed for a 25,000 square foot Borders bookstore and an 8,200 square foot Zany Brainy children s educational toy store. Final governmental approvals have been obtained for the redevelopment of the Company s 61,000 square foot Shops at Fairfax located in the city of Fairfax, Virginia, one of Washington, D.C. s most prosperous suburbs. The main building of this shopping center contained an enclosed mini-mall of approximately 30,000 square feet which has been demolished in preparation for the development of a 53,000 square foot SuperFresh grocery store and 7,500 square feet of new service tenant space. Completion of construction is scheduled for the fall of 1999. This redevelopment is an opportunity to create value by providing more efficient parking and new landscaping, SAUL C these tenants are currently open 8 Newly renovated French Market in Oklahoma City, Oklahoma (left) and Thruway in Winston-Salem, North Carolina (right).

Tenants enjoy a spectacular view of the Nation s Capitol from 601 Pennsylvania Avenue balconies.

Message TO OUR SHAREHOLDERS and repositioning the property as a very desirable grocery anchored neighborhood shopping center. Office Activity Demand for space in the office submarkets in which the Company operates remains healthy. The 741,000 square feet of high-rise office and office/flex space which the Company currently owns is over 95% leased. In April 1998, we acquired a newly constructed, 100% leased office/flex building adjacent to our Avenel Business Park in Gaithersburg, Maryland. The building contains 46,000 square feet of leaseable area. In July, we began construction of an additional 27,000 square feet of space at Avenel. These buildings were substantially completed in January 1999, with 30% of the new space under lease prior to building shell completion, and 46% currently leased. The Avenel Business Park now contains over 350,000 square feet of space in eleven one-story office/ flex buildings targeting users primarily in the life sciences and technology industries. Avenel is currently over 93% leased. in Northern Virginia s historic Old Town Alexandria. The project is well located on a two acre site along Alexandria s main street. Demolition of the Company s existing 41,500 square foot building, formerly leased to Mastercraft furniture, commenced in February 1999. Construction is scheduled to be completed by the summer of 2000. The project will be comprised of two four-story buildings presenting a brick and cast stone exterior facade to blend well with the surrounding historic neighborhood. Each building will feature a glass curtain wall overlooking a spacious courtyard. Amenities will include 3-story atrium lobbies, a fitness center, concierge service, a 600 space parking structure and the latest computerized energy management system. The Company just commenced SAUL its most significant development C of the past five years. The Company will construct a new 230,000 square foot Class A mixed-use office/retail complex along North Washington Street Rendering of the 230,000 square foot mixed-use office/retail complex to be constructed in Old Town Alexandria, Virginia. 10

The street level will have 45,000 square feet of retail space. Office space will total 185,000 square feet, with the top floor containing walk-out terraces. A $38 million construction loan was closed in January 1999, which is anticipated to fund all project costs. Capitalization The past year was a period of generally sound real estate fundamentals but very turbulent capital market behavior. The Company s need to access new sources of debt and equity capital in 1998 and 1999 has been minimal. Fixed rate debt currently comprises 93% of total outstanding indebtedness, the majority of which was procured in 1996 and 1997. The weighted average maturity of the Company s $273 million fixed rate debt is over 13 years and the weighted average interest rate is an attractive 7.9%. We have a comfortable level of credit line borrowing capacity of approximately $40 million, providing available capital for our defined business plan of internal growth through redevelopment, renovation and expansion. At year end 1998, the Company had total combined debt and equity capitalization of over $560 million. With $291 million of total debt, this capital structure provides the benefits of prudent leverage and a comfortable interest coverage ratio of 2.4 during the latest quarter of operations, an increase from 2.3 a year earlier. With expectations of modest economic growth widely predicted for 1999, we view our portfolio as one of solid real estate fundamentals and positioned for continued cash flow growth. The success of our core internal growth strategy into the year 2000 hinges primarily on what has sustained our past growth the prime location of the vast majority of our assets. ENTERS On behalf of our Board of Directors, we remain committed to our plan of internal growth through renovation and redevelopment and we wish to express our thanks to you, our shareholders, for your investment in our future. For the Board B. Francis Saul II Chairman of the Board March 3, 1999 11

Portfolio PROPERTIES Saul Centers properties are located primarily in the suburban Washington, V D.C./Baltimore area, representing 69% of the portfolio s gross leasable area. SHOPPING Location of Gross Leasable CENTERS Property Square Feet Ashburn Village Ashburn, VA 108,204 Beacon Center Alexandria, VA 355,736 Belvedere Baltimore, MD 54,941 Boulevard Fairfax, VA 56,578 Clarendon Arlington, VA 6,940 Clarendon Station Arlington, VA 4,868 Flagship Center Rockville, MD 21,500 French Market Oklahoma City, OK 213,668 Germantown Germantown, MD 26,241 Giant Baltimore, MD 70,040 The Glen Lake Ridge, VA 112,639 Great Eastern District Heights, MD 255,448 Hampshire Langley Langley Park, MD 134,425 Leesburg Pike Baileys Crossroads, VA 97,888 Lexington Mall Lexington, KY 315,747 Lumberton Plaza Lumberton, NJ 189,898 North Washington Alexandria, VA 41,500 Olney Olney, MD 53,765 Park Road Center Washington, DC 106,650 Ravenwood Baltimore, MD 87,750 Seven Corners Falls Church, VA 567,994 SHOPPING Location of Gross Leasable CENTERS (Cont.) Property Square Feet Shops at Fairfax Fairfax, VA 60,703 Southdale Glen Burnie, MD 479,749 Southside Plaza Richmond, VA 352,964 Sunshine City Atlanta, GA 167,591 Thruway Winston-Salem, NC 345,194 Village Center Centreville,VA 142,881 West Park Oklahoma City, OK 77,810 White Oak Silver Spring, MD 480,156 Shopping Center Total 4,989,468 OFFICE PROPERTIES Avenel Business Park Gaithersburg, MD 331,445 601 Pennsylvania Avenue Washington, DC 225,153 Van Ness Square Washington, DC 157,697 Office Properties Total 714,295 INDUSTRIAL PROPERTY Crosstown Business Center Tulsa, OK 197,135 Industrial Property Total 197,135 TOTAL PORTFOLIO PROPERTIES 5,900,898 12

Report OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Saul Centers, Inc.: We have audited the accompanying consolidated balance sheets of Saul Centers, Inc. (a Maryland corporation) and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of operations, stockholders equity and cash flows for the three years ended December 31, 1998, 1997 and 1996. These financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Saul Centers, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years ended December 31, 1998, 1997 and 1996 in conformity with generally accepted accounting principles. As explained in Note 2 to the financial statements, effective June 30, 1998, the Company changed its method of accounting for percentage rent. Arthur Andersen LLP Washington, D.C. February 8, 1999 13

Saul Centers, Inc. CONSOLIDATED BALANCE SHEETS December 31, (Dollars in thousands) 1998 1997 Assets Real estate investments Land $ 64,339 $ 65,630 Buildings and equipment 283,722 269,638 348,061 335,268 Accumulated depreciation (101,910) (92,615) 246,151 242,653 Construction in progress 4,506 974 Cash and cash equivalents 2,395 688 Accounts receivable and accrued income, net 6,347 6,190 Prepaid expenses 6,873 5,423 Deferred debt costs, net 3,604 3,853 Other assets 1,158 1,161 Total assets $ 271,034 $ 260,942 Liabilities Notes payable $ 290,623 $ 284,473 Accounts payable, accrued expenses and other liabilities 14,856 13,093 Deferred income 2,839 1,430 Total liabilities 308,318 298,996 Minority interests -- -- Stockholders equity (deficit) Common stock, $0.01 par value, 30,000,000 shares authorized, 12,836,378 and 12,428,145 shares issued and outstanding, respectively 129 124 Additional paid-in capital 31,967 20,447 Accumulated deficit (69,380) (58,625) Total stockholders equity (deficit) (37,284) (38,054) Total liabilities and stockholders equity $ 271,034 $ 260,942 14 The accompanying notes are an integral part of these statements.

Saul Centers, Inc. CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, (Dollars in thousands, except per share amounts) 1998 1997 1996 Revenue Base rent $ 55,542 $ 51,779 $ 49,814 Expense recoveries 9,911 9,479 9,301 Percentage rent 2,755 2,948 2,924 Other 2,375 3,511 1,984 Total revenue 70,583 67,717 64,023 Operating expenses Property operating expenses 7,830 8,075 8,069 Provision for credit losses 418 505 457 Real estate taxes 6,128 6,084 5,914 Interest expense 22,627 20,308 18,509 Amortization of deferred debt expense 419 1,729 2,857 Depreciation and amortization 12,578 10,642 10,860 General and administrative 3,393 3,379 3,095 Total operating expenses 53,393 50,722 49,761 Operating income 17,190 16,995 14,262 Non-operating item Sales of interest rate protection agreements -- (4,392) (972) Net income before extraordinary item, cumulative effect of change in accounting method and minority interests 17,190 12,603 13,290 Extraordinary item Early extinguishment of debt (50) (3,197) (587) Cumulative effect of change in accounting method (771) -- -- Net income before minority interests 16,369 9,406 12,703 Minority interests Minority share of income (4,354) (2,483) (3,430) Distributions in excess of earnings (2,886) (4,371) (3,422) Total minority interests (7,240) (6,854) (6,852) Net income $ 9,129 $ 2,552 $ 5,851 Net income per share (basic and dilutive) Net income before extraordinary item, cumulative effect of change in accounting method and minority interests $ 1.00 $ 0.76 $ 0.81 Extraordinary item -- (0.19) (0.04) Cumulative effect of change in accounting method (0.05) -- -- Net income before minority interests $ 0.95 $ 0.57 $ 0.77 Net income $ 0.72 $ 0.21 $ 0.49 The accompanying notes are an integral part of these statements. 15

Saul Centers, Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY Additional Common Paid-in Accumulated (Dollars in thousands, except per share amounts) Stock Capital Deficit Total Stockholders' equity (deficit): Balance, December 31, 1995 $ 119 $ 12,511 $ (29,097) $ (16,467) Issuance of 257,454 shares of common stock 2 3,439 -- 3,441 Net income -- -- 5,851 5,851 Distributions ($1.17 per share) -- -- (14,036) (14,036) Distributions payable ($.39 per share) -- -- (4,729) (4,729) Balance, December 31, 1996 121 15,950 (42,011) (25,940) Issuance of 275,374 shares of common stock 3 4,497 -- 4,500 Net income -- -- 2,552 2,552 Distributions ($1.17 per share) -- -- (14,334) (14,334) Distributions payable ($.39 per share) -- -- (4,832) (4,832) Balance, December 31, 1997 124 20,447 (58,625) (38,054) Issuance of 408,233 shares of common stock 5 6,629 -- 6,634 Issuance of 405,532 convertible limited partnership units in the Operating Partnership -- 4,891 -- 4,891 Net income -- -- 9,129 9,129 Distributions ($1.17 per share) -- -- (14,899) (14,899) Distributions payable ($.39 per share) -- -- (4,985) (4,985) Balance, December 31, 1998 $ 129 $ 31,967 $ (69,380) $ (37,284) 16 The accompanying notes are an integral part of these statements.

Saul Centers, Inc. CONSOLIDATED STATEMENTS OF CASH FLOW For the Years Ended December 31, (Dollars in thousands) 1998 1997 1996 Cash flows from operating activities: Net income $ 9,129 $ 2,552 $ 5,851 Adjustments to reconcile net income to net cash provided by operating activities: Minority interests 7,240 6,854 6,852 Loss on sale of interest rate protection agreements -- 4,392 972 Cumulative effect of change in accounting method 771 -- -- Loss on early extinguishment of debt 50 3,197 587 Depreciation and amortization 12,997 12,371 13,717 Provision for credit losses 418 505 457 Increase in accounts receivable (1,346) (406) (45) Increase in prepaid expenses (2,742) (1,426) (1,136) Decrease (increase) in other assets 3 2,548 (961) Increase (decrease) in accounts payable and other liabilities 1,763 (1,640) 3,019 Increase (decrease) in deferred income 1,409 (11) 364 Other, net (6) -- -- Net cash provided by operating activities 29,686 28,936 29,677 Cash flows from investing activities: Additions to real estate investments (6,607) (4,377) (4,469) Additions to construction in progress (8,169) (11,717) (3,566) Net cash used in investing activities (14,776) (16,094) (8,035) Cash flows from financing activities: Proceeds from notes payable 20,900 223,600 98,620 Repayments on notes payable (18,407) (212,388) (98,442) Proceeds from sale of interest rate protection agreements -- 1,370 681 Note prepayment fees -- (95) -- Additions to deferred debt expense (220) (3,159) (961) Proceeds from the issuance of common stock and convertible limited partnership units in the Operating Partnership 11,648 4,500 3,441 Distributions to common stockholders and holders of convertible limited partnership units in the Operating Partnership (27,124) (26,020) (25,617) Net cash used in financing activities (13,203) (12,192) (22,278) Net increase (decrease) in cash 1,707 650 (636) Cash, beginning of year 688 38 674 Cash, end of year $ 2,395 $ 688 $ 38 Supplemental disclosures of cash flow information: Cash paid during the year for: Interest net of amount capitalized $ 22,575 $ 19,804 $ 18,829 The accompanying notes are an integral part of these statements. 17

Notes TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION, FORMATION, AND BASIS OF PRESENTATION Organization Saul Centers, Inc. ( Saul Centers ) was incorporated under the Maryland General Corporation Law on June 10, 1993. The authorized capital stock of Saul Centers consists of 30,000,000 shares of common stock, having a par value of $0.01 per share, and 1,000,000 shares of preferred stock. Each holder of common stock is entitled to one vote for each share held. Saul Centers, together with its wholly owned subsidiaries and the limited partnerships of which Saul Centers or one of its subsidiaries is the sole general partner, are referred to collectively as the Company. Saul Centers operates as a real estate investment trust under the Internal Revenue Code of 1986, as amended (a REIT ). Formation and Structure of Company Saul Centers was formed to continue and expand the shopping center business previously owned and conducted by the B.F. Saul Real Estate Investment Trust, the B.F. Saul Company, Chevy Chase Bank, F.S.B. and certain other affiliated entities (collectively, The Saul Organization ). On August 26, 1993, The Saul Organization transferred to Saul Holdings Limited Partnership, a newly formed Maryland limited partnership (the Operating Partnership ), and two newly formed subsidiary limited partnerships (the Subsidiary Partnerships ) 26 shopping center properties, one office property, one research park and one office/retail property and the management functions related to the transferred properties. Since its formation, the Company has purchased three additional community and neighborhood shopping center properties, an office property and a land parcel which it developed into a neighborhood shopping center. The Company is currently in the predevelopment and approval process of converting a shopping center to an industrial/warehouse use. Therefore, as of December 31, 1998, the Company s properties (the Current Portfolio Properties ) consisted of 29 operating shopping center properties (the Shopping Centers ), a property planned to be converted to an industrial/warehouse facility (the Industrial Property ) and four predominantly office properties (the Office Properties ). To facilitate the placement of collateralized mortgage debt, the Company established Saul QRS, Inc. and SC Finance Corporation, each of which is a wholly owned subsidiary of Saul Centers. Saul QRS, Inc. was established to succeed to the interest of Saul Centers as the sole general partner of Saul Subsidiary I Limited Partnership. As a consequence of the transactions constituting the formation of the Company, Saul Centers serves as the sole general partner of the Operating Partnership and of Saul Subsidiary II Limited Partnership, while Saul QRS, Inc., Saul Centers wholly owned subsidiary, serves as the sole general partner of Saul Subsidiary I Limited Partnership. The remaining limited partnership interests in Saul Subsidiary I Limited Partnership and Saul Subsidiary II Limited Partnership are held by the Operating Partnership as the sole limited partner. Through this structure, the Company owns 100% of the Current Portfolio Properties. Basis of Presentation The accompanying financial statements of the Company have been presented on the historical cost basis of The Saul Organization because of affiliated ownership and common management and because the assets and liabilities were the subject of a business combination with the Operating Partnership, the Subsidiary Partnerships and Saul Centers, all newly formed entities with no prior operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations The Company, which conducts all of its activities through its subsidiaries, the Operating Partnership and Subsidiary Partnerships, engages in the ownership, operation, management, leasing, acquisition, renovation, expansion, development and financing of community and neighborhood shopping centers and office properties, primarily in the Mid-Atlantic region. A majority of the Shopping Centers are anchored by several major tenants. Eighteen of the 30 Shopping Centers are anchored by a grocery store and offer primarily day-today necessities and services. As of December 1998, no single Shopping Center accounted for more than 11.4% of the total Shopping Center gross leasable area. Only one retail tenant, Giant Food, at 7.1%, accounted for more than 1.7% of the Company s 1998 total revenues. No office tenant other than the United States General Service Administration, at 10.4%, accounted for more than 1.8% of 1998 total revenues. 18

Notes TO CONSOLIDATED FINANCIAL STATEMENTS Principles of Consolidation The accompanying consolidated financial statements of the Company include the accounts of Saul Centers, its subsidiaries, and the Operating Partnership and Subsidiary Partnerships which are majority owned by Saul Centers. All significant intercompany balances and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Real Estate Investment Properties Real estate investment properties are stated at the lower of depreciated cost or fair value less cost to sell. Management believes that these assets have generally appreciated in value and, accordingly, the aggregate current value exceeds their aggregate net book value and also exceeds the value of the Company s liabilities as reported in these financial statements. These financial statements are prepared in conformity with generally accepted accounting principles, and accordingly, do not report the current value of the Company s real estate assets. Interest, real estate taxes and other carrying costs are capitalized on projects under construction. Once construction is substantially complete and the assets are placed in service, rental income, direct operating expenses, and depreciation associated with such properties are included in current operations. Expenditures for repairs and maintenance are charged to operations as incurred. Repairs and maintenance expense totaled $2,616,000, $2,479,000 and $2,730,000, for calendar years 1998, 1997, and 1996, respectively, and is included in operating expenses in the accompanying financial statements. Interest expense capitalized totaled $215,000, $297,000 and $384,000, for calendar years 1998, 1997 and 1996, respectively. In the initial rental operations of development projects, a project is considered substantially complete and available for occupancy upon completion of tenant improvements, but no later than one year from the cessation of major construction activity. Substantially completed portions of a project are accounted for as separate projects. Depreciation is calculated using the straight-line method and estimated useful lives of 33 to 50 years for buildings and up to 20 years for certain other improvements. Leasehold improvements are amortized over the lives of the related leases using the straight-line method. Accounts Receivable and Accrued Income Accounts receivable primarily represent amounts currently due from tenants in accordance with the terms of the respective leases. In addition, accounts receivable included $1,442,848, $1,663,000 and $1,913,000, at December 31, 1998, 1997 and 1996, respectively, representing minimum rental income accrued on a straight-line basis to be paid by tenants over the term of the respective leases. Receivables are reviewed monthly and reserves are established with a charge to current period operations when, in the opinion of management, collection of the receivable is doubtful. Accounts receivable in the accompanying financial statements are shown net of an allowance for doubtful accounts of $657,000, $506,000 and $427,000, at December 31, 1998, 1997 and 1996, respectively. (In thousands) Allowance for Doubtful Accounts For the Years Ended December 31, 1998 1997 1996 Beginning Balance $ 506 $ 427 $ 169 Provision for Credit Losses 418 505 457 Charge-offs (267) (426) (199) Ending Balance $ 657 $ 506 $ 427 Deferred Debt Costs Deferred debt costs consists of fees and costs incurred to obtain long-term financing and interest rate protection agreements. These fees and costs are being amortized over the terms of the respective loans or agreements. Deferred debt costs in the accompanying financial statements are shown net of accumulated amortization of $589,000, $171,000 and $6,240,000, at December 31, 1998, 1997 and 1996, respectively. 19

Notes TO CONSOLIDATED FINANCIAL STATEMENTS Revenue Recognition Rental and interest income is accrued as earned except when doubt exists as to collectibility, in which case the accrual is discontinued. When rental payments due under leases vary from a straight-line basis because of free rent periods or stepped increases, income is recognized on a straight-line basis in accordance with generally accepted accounting principles. Expense recoveries represent property operating expenses billed to the tenants, including common area maintenance, real estate taxes and other recoverable costs. Expense recoveries are recognized in the period the expenses are incurred. Additional rental income based on tenant s revenues ( percentage rent ) is accrued at the time a tenant reports sales exceeding a specified breakpoint. Income Taxes The Company made an election to be treated, and intends to continue operating so as to qualify as a REIT under sections 856 through 860 of the Internal Revenue Code of 1986, as amended, commencing with its taxable year ending December 31, 1993. A REIT generally will not be subject to federal income taxation on that portion of its income that qualifies as REIT taxable income to the extent that it distributes at least 95% of its REIT taxable income to stockholders and complies with certain other requirements. Therefore, no provision has been made for federal income taxes in the accompanying financial statements. As of December 31, 1998 and 1997, the total tax basis of the Company s assets was $296,658,000 and $288,082,000, and the tax basis of the liabilities was $298,280,000 and $293,223,000, respectively. Directors Deferred Compensation Plan A Deferred Compensation Plan was established by Saul Centers, effective January 1, 1994, for the benefit of its directors and their beneficiaries. Before the beginning of any calendar year, a director may elect to defer all or part of his or her director s fees to be earned in that year and the following years. A director has the option to have deferred director s fees paid in cash, in shares of common stock or in a combination of cash and shares of common stock. If the director elects to have the deferred fees paid in stock, the number of shares allocated to the director is determined based on the market value of the common stock on the day the deferred director s fee was earned. Deferred compensation of $180,550, $144,500 and $118,950, has been reported in the Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996, respectively. The Company has registered 70,000 shares for use under the plan. As of December 31, 1998, 54,185 shares had been credited to the directors deferred fee accounts. New Accounting Pronouncements In June 1997, the Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( SFAS ) No. 130 Reporting Comprehensive Income which establishes standards for the reporting and display of comprehensive income in the Company s financial statements. The Company adopted this standard in the first quarter of 1998. The Company had no comprehensive income during the year ended December 31, 1998. In September 1997, the FASB issued SFAS No. 131 Disclosures about Segments of an Enterprise and Related Information which establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also established standards for related disclosures about products and services, geographic areas, and major customers. Disclosures required by this new standard are presented in Note 16. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities which establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. SFAS 133 is effective for fiscal years beginning after June 15, 1999. The Company doesn t own derivative instruments nor does it engage in hedging activities, and therefore expects that SFAS 133 will not have an impact on the Company s financial condition or its results of operations. 20

Notes TO CONSOLIDATED FINANCIAL STATEMENTS Change In Accounting Method On May 21, 1998, the Emerging Issues Task Force ( EITF ) discussed Issue 98-9 Accounting for Contingent Rent In Interim Financial Periods and reached a consensus that lessors should defer the accounting recognition of contingent rent, such as percentage rent, until the specific tenant sales breakpoint is achieved. The Company s prior accounting method, which was permitted under generally accepted accounting principles, recognized percentage rent when a tenant s achievement of its sales breakpoint was considered probable. This EITF consensus was implemented retroactively to January 1, 1998, as a change in accounting method. The new accounting method did not affect the amount of percentage rent income reported on an annual basis, but did impact the recognition of percentage rent income reported on an interim basis by increasing revenues the Company reported in the first and fourth quarters and decreasing revenues reported in the second and third quarters. The change in accounting method has no impact on the Company s cash flows. As a result of adoption of EITF Issue 98-9, the Company recorded a $771,000 charge for the cumulative effect of change in accounting method, which is included in the consolidated statement of operations for the year ended December 31, 1998. Construction in Progress Construction in progress includes the costs of active development projects and other predevelopment project costs. Development costs include direct construction costs and indirect costs such as architectural, engineering, construction management and carrying costs consisting of interest, real estate taxes and insurance. Construction in progress balances as of December 31, 1998 and 1997 are as follows: Construction in Progress (In thousands) December 31, 1998 1997 Avenel V $ 2,800 $ -- French Market 949 807 Shops At Fairfax 702 -- Other development costs 55 167 Ending Balance $ 4,506 $ 974 Cash and Cash Equivalents Cash and cash equivalents includes cash and short-term investments with maturities of three months or less. Per Share Data Per share data is calculated in accordance with SFAS No. 128, Earnings Per Share. The Company has no dilutive securities, therefore, basic and diluted earnings per share are identical. Net income before minority interests is presented on a fully converted basis, that is, assuming the limited partners exercise their right to convert their partnership ownership into shares of Saul Centers and is computed using weighted average shares of 17,233,047, 16,690,417 and 16,423,984, shares for the years ended December 31, 1998, 1997 and 1996, respectively. Per share data relating to net income after minority interests is computed on the basis of 12,643,639, 12,297,254 and 12,030,821, weighted average common shares for the years ended December 31, 1998, 1997 and 1996, respectively. Reclassifications Certain reclassifications have been made to the prior year financial statements to conform to the current year presentation. The reclassifications have no impact on operating results previously reported. 3. MINORITY INTERESTS- HOLDERS OF CONVERTIBLE LIMITED PARTNERSHIP UNITS IN THE OPERATING PARTNERSHIP The Saul Organization has a 27.2% limited partnership interest, represented by 4,798,695 convertible limited partnership units, in the Operating Partnership, as of December 31, 1998. These Convertible Limited Partnership Units are convertible into shares of Saul Centers common stock on a one-for-one basis, provided the rights may not be exercised at any time that The Saul Organization owns, directly or indirectly, in the aggregate more than 24.9% of the outstanding equity securities of Saul Centers. The impact of the Saul Organization s 27.2% limited partnership interest in the Operating Partnership is reflected as minority interests in the accompanying financial statements. 21

Notes TO CONSOLIDATED FINANCIAL STATEMENTS 4. NOTES PAYABLE December 31, 1998 The Company assumed a $3.7 million loan when it acquired Avenel IV on April 1, 1998. In September 1998, the Company closed a $6.4 million permanent fixed rate loan to replace the variable rate loan assumed on the acquisition of Avenel IV. The balance of the loan, $2.7 million, was used to fund construction of the new Avenel V development. The new loan term is 13 years and requires monthly principal and interest payments based upon a 25 year amortization schedule and an interest rate of 7.09%. Borrowings totaled $18.0 million on the Company s $60.0 million unsecured revolving credit facility at December 31, 1998, leaving $42.0 million available for future use. Notes payable totaled $290.6 million at December 31, 1998, as follows: Notes Payable Principal Interest Scheduled (In thousands) Outstanding Rate Maturity Mortgage Notes Payable $ 144,814 (a) 7.67% fixed October 2012 79,464 (b) 8.52% fixed December 2011 37,515 (c) 7.88% fixed January 2013 10,629 (d) 7.25% fixed May 2004 201 8.00% fixed January 2000 Subtotal 272,623 Revolving Credit Facility 18,000 (e) 6.82% variable September 2000 Total Notes Payable $ 290,623 (a) The loan is collateralized by nine shopping centers. (b) The loan is collateralized by Avenel Business Park, Van Ness Square and four shopping centers - Ashburn Village, Leesburg Pike, Lumberton Plaza and Village Center. The loan was amended during 1998 to include new borrowings of $6.4 million at a rate of 7.09%. Avenel IV and Avenel V (under construction at year-end 1998) were added as collateral. The 8.52% blended interest rate is the weighted average of the initial loan rate and the additional borrowings rate. (c) The loan is collateralized by 601 Pennsylvania Avenue. (d) For the final five years of the term of the loan, beginning in June 1999, the interest rate is fixed at the 1-year Treasury Securities rate effective March 16, 1999 plus 2.00%. The loan is collateralized by The Glen shopping center. (e) The facility is a revolving credit facility totaling $60.0 million. Interest expense is calculated based upon the 1,2,3 or 6 month LIBOR rate plus a spread of 1.375% to 1.625% (determined by certain debt service coverage and leverage tests) or upon the bank s reference rate plus 1/2% at the Company s option. The line may be extended one year with payment of a fee of 1/4% at the Company s option. The interest rate in effect on December 31, 1998 was based on a weighted average LIBOR of 5.32% and spread of 1.5%. 22

Notes TO CONSOLIDATED FINANCIAL STATEMENTS Notes payable balances outstanding at December 31, 1998 have a weighted average remaining term of 12.5 years, and a weighted average interest rate of 7.84%. Of the $290.6 million total debt at December 31, 1998, $272.6 million was fixed rate (93.8% of the total notes payable) and $18.0 million was variable rate (6.2% of the total notes payable). The December 31, 1998 depreciated cost of properties collateralizing the mortgage notes payable totaled $192.0 million. Notes payable of $272.4 million at December 31, 1998 require monthly installments of principal and interest, with principal amortization on schedules averaging approximately 20 years. The $0.2 million note requires monthly interest and an annual principal payment of $0.1 million. The remaining notes payable totaling $18.0 million at December 31, 1998 require monthly installments of interest only. Notes payable at December 31, 1998 totaling $211.0 million are guaranteed by members of The Saul Organization. As of December 31, 1998, the scheduled maturities of all debt for years ended December 31, are as follows: (In thousands) Debt Maturity Schedule 1999 $ 5,256 2000 23,648 2001 6,057 2002 5,735 2003 6,215 Thereafter 243,712 $ 290,623 December 31, 1997 During 1997 the Company repaid a total of $185.5 million of variable rate mortgage notes which were outstanding at December 31, 1996, with the net proceeds of a $147.0 million 15-year fixed rate mortgage note and a $38.5 million 16-year fixed rate mortgage note. The $44.0 million secured revolving credit facility in effect at December 31, 1996 was replaced with a $60.0 million unsecured revolving credit facility during 1997. Notes payable totaled $284.5 million at December 31, 1997. Notes payable balances outstanding at December 31, 1997 had a weighted average remaining term of 13.7 years, and a weighted average interest rate of 7.90%. Of the $284.5 million total debt at December 31, 1997, $271.0 million was fixed rate (95.3% of the total notes payable) and $13.5 million was variable rate (4.7% of the total notes payable). The December 31, 1997 depreciated cost of properties collateralizing the mortgage notes payable totaled $192.7 million. Notes payable of $270.7 million at December 31, 1997 required monthly installments of principal and interest, with principal amortization on schedules averaging approximately 20 years. The $0.3 million note required monthly interest and an annual principal payment of $0.1 million. The remaining notes payable totaling $13.5 million at December 31, 1997 required monthly installments of interest only. Notes payable at December 31, 1997 totaling $209.1 million were guaranteed by members of The Saul Organization. 5. LEASE AGREEMENTS Lease income includes primarily base rent arising from noncancellable commercial leases. Base rent for the years ended December 31, 1998, 1997 and 1996, amounted to $55,542,000, $51,779,000 and $49,814,000, respectively. Future base rent under noncancellable leases for years ended December 31, are as follows: (In thousands) Future Base Rental Income 1999 $ 55,984 2000 50,574 2001 45,356 2002 38,343 2003 31,287 Thereafter 261,869 $ 483,413 The majority of the leases also provide for rental increases and expense recoveries based on increases in the Consumer Price Index or increases in operating expenses, or both. These increases generally are payable in equal installments throughout the year based on estimates, with adjustments made in the succeeding year. 23

Notes TO CONSOLIDATED FINANCIAL STATEMENTS Expense recoveries for the years ended December 31, 1998, 1997 and 1996 amounted to $9,911,000, $9,479,000 and $9,301,000, respectively. In addition, certain retail leases provide for percentage rent based on sales in excess of the minimum specified in the tenant s lease. Percentage rent amounted to $2,755,000, $2,948,000 and $2,924,000, for the years ended December 31, 1998, 1997 and 1996, respectively. 6. LONG-TERM LEASE OBLIGATIONS Certain properties are subject to noncancellable longterm leases which apply to land underlying the Shopping Centers. Certain of the leases provide for periodic adjustments of the basic annual rent and require the payment of real estate taxes on the underlying land. The leases will expire between 2058 and 2068. Reflected in the accompanying financial statements is minimum ground rent expense of $152,000 for each of the years ended December 31, 1998, 1997, and 1996. The minimum future rental commitments under these ground leases are as follows: (In thousands) Ground Lease Rental Commitments Annual Total 1999-2003 Thereafter Beacon Center $ 47 $ 3,465 Olney 45 4,646 Southdale 60 3,365 $ 152 $ 11,476 The Company s Flagship Center consists of two developed outparcels that are part of a larger adjacent community shopping center formerly owned by The Saul Organization and sold to an affiliate of a tenant in 1991. The Company has a 90-year ground leasehold interest which commenced in September 1991 with a minimum rent of one dollar per year. 7. SHAREHOLDERS EQUITY AND MINORITY INTERESTS The Consolidated Statement of Operations for the year ended December 31, 1998 includes a charge for minority interests of $7,240,000, consisting of $4,354,000 related to The Saul Organization s share of the net income for the year and $2,886,000 related to distributions to minority interests in excess of allocated net income for the year. The charge for the year ended December 31, 1997 of $6,854,000 consists of $2,483,000 related to The Saul Organization s share of net income for the year and $4,371,000 related to distributions to minority interests in excess of allocated net income for the year. The charge for the year ended December 31, 1996 of $6,852,000 consists of $3,430,000 related to The Saul Organization s share of the net income for the year and $3,422,000 related to distributions to minority interests in excess of allocated net income for the year. 8. RELATED-PARTY TRANSACTIONS In April 1998, the Company purchased, through its operating partnership, a 46,227 square foot office/flex property known as Avenel IV. The $5,600,000 purchase price consisted of $3,657,000 in variable rate debt assumption, with the balance paid through the issuance of 105,922 new units in Saul Centers operating partnership. The seller was a member of The Saul Organization. Chevy Chase Bank, F.S.B. leases space in twelve of the properties. Total rental income from Chevy Chase Bank, F.S.B. amounted to $1,192,000, $1,181,000 and $1,063,000, for the years ended December 31, 1998, 1997 and 1996, respectively. The Chairman and Chief Executive Officer, the President and a Senior Vice President of the Company are officers of The Saul Organization but devote a substantial amount of time to the management of the Company. The annual compensation for these officers is fixed by the Compensation Committee of the Board of Directors. 24